Chapter 16 notes

oligopoly

BETWEEN MONOPOLY AND PERFECT COMPETITION

• Types of Imperfectly Competitive Markets– Oligopoly• Only a few sellers, each offering a similar or identical

product to the others.

– Monopolistic Competition• Many firms selling products that are similar but not

identical.

Figure 1 The Four Types of Market Structure

• Tap water• Cable TV

Monopoly(Chapter 15)

• Novels• Movies

MonopolisticCompetition(Chapter 17)

• Tennis balls• Crude oil

Oligopoly(Chapter 16)

Number of Firms?

Perfect

• Wheat• Milk

Competition(Chapter 14)

Type of Products?

Identicalproducts

Differentiatedproducts

Onefirm

Fewfirms

Manyfirms

MARKETS WITH ONLY A FEW SELLERS

• Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.

• Characteristics of an Oligopoly Market– Few sellers offering similar or identical products– Interdependent firms– Best off cooperating and acting like a monopolist

by producing a small quantity of output and charging a price above marginal cost

A Duopoly Example• A duopoly is an oligopoly with only two members.

It is the simplest type of oligopoly.• Price and Quantity Supplied– The price of water in a perfectly competitive market

would be driven to where the marginal cost is zero:• P = MC = $0• Q = 120 gallons

– The price and quantity in a monopoly market would be where total profit is maximized:• P = $60• Q = 60 gallons

Table 1 The Demand Schedule for Water

A Duopoly Example

• Price and Quantity Supplied– The socially efficient quantity of water is 120

gallons, but a monopolist would produce only 60 gallons of water.

– So what outcome then could be expected from duopolists?

The Market for Water

Quantity of Output0

Cost$120

$60

60

MC is constant and = $0.

120

Demand

Marginal Revenue

In a competitive market, quantity would equal 120 and P = MC = $0.

A monopoly would produce 60 gallons and charge $60. Note that P > MC.

Total industry output with a duopoly will probably exceed 60, but be less than 120.

The Equilibrium for an Oligopoly

• When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition.

• The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

Competition, Monopolies, and Cartels

• The duopolists may agree on a monopoly outcome.–Collusion• An agreement among firms in a market

about quantities to produce or prices to charge.

–Cartel• A group of firms acting in unison.

Cont’d

• Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

How the Size of an Oligopoly Affects the Market Outcome

• How increasing the number of sellers affects the price and quantity:– The output effect: Because price is above marginal

cost, selling more at the going price raises profits.– The price effect: Raising production will increase

the amount sold, which will lower the price and the profit per unit on all units sold.

How the Size of an Oligopoly Affects the Market Outcome

• As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market.

• The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

GAME THEORY AND THE ECONOMICS OF COOPERATION

• Game theory is the study of how people behave in strategic situations.

• Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

GAME THEORY AND THE ECONOMICS OF COOPERATION

• Because the number of firms in an oligopolistic market is small, each firm must act strategically.

• Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

The Prisoners’ Dilemma

• The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation.

• Often people (firms) fail to cooperate with one another even when cooperation would make them better off.

• The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Figure 2 The Prisoners’ Dilemma

Bonnie’ s Decision

Confess

Confess

Bonnie gets 8 years

Clyde gets 8 years

Bonnie gets 20 years

Clyde goes free

Bonnie goes free

Clyde gets 20 years

gets 1 yearBonnie

Clyde gets 1 year

Remain Silent

RemainSilent

Clyde’sDecision

Oligopolies as a Prisoners’ Dilemma

• The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.

• Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

• Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits.

The Equilibrium for an Oligopoly

• A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

Figure 3 Jack and Jill’s Oligopoly Game

Jack’s Decision

High Production

High Production: 40 Gal.

Jack gets $1,600 profit

Jill gets $1,600 profit

Jack gets $1,500 profit

Jill gets $2,000 profit

Jack gets $2,000 profit

Jill gets $1,500 profit

Jack gets $1,800 profit

Jill gets $1,800 profit

Low Production: 30 gal.

LowProduction

Jill’sDecision

40 gal.

30 gal.

Figure 4 An Arms-Race GameDecision of the United States (U.S.)

Arm

Arm

U.S. at risk

USSR at risk

U.S. at risk and weak

USSR safe and powerful

U.S. safe and powerful

USSR at risk and weak

U.S. safe

USSR safe

Disarm

Disarm

Decision of the Soviet Union (USSR)

Figure 5 A Common-Resource GameExxon ’ s Decision

Drill TwoWells

Drill Two Wells

Exxon gets $4million profit

Chevron gets $4million profit

Chevron gets $6million profit

Exxon gets $3million profit

Chevron gets $3million profit

Exxon gets $6million profit

Chevron gets $5million profit

Exxon gets $5million profit

Drill One Well

Drill OneWell

Chevron’sDecision

Why People Sometimes Cooperate

• Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.

• Example: OPEC tries to set production levels for member countries; was successful from 1973-1985 but countries began arguing about production and started to produce more and drive down price of crude oil.

PUBLIC POLICY TOWARD OLIGOPOLIES

• Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high.

Restraint of Trade and the Antitrust Laws

• Antitrust laws make it illegal to restrain trade or attempt to monopolize a market.– Sherman Antitrust Act of 1890 – Clayton Antitrust Act of 1914

Controversies over Antitrust Policy

• Antitrust policies sometimes may not allow business practices that have potentially positive effects:– Resale price maintenance – Predatory pricing– Tying

Controversies over Antitrust Policy

• Resale Price Maintenance (or fair trade) – occurs when suppliers (like wholesalers) require

retailers to charge a specific amount• Predatory Pricing– occurs when a large firm begins to cut the price of

its product(s) with the intent of driving its competitor(s) out of the market

• Tying– when a firm offers two (or more) of its products

together at a single price, rather than separately

The Microsoft Case

• Should Microsoft be able to integrate its internet browser into its Windows operating system?

• Gov’t claimed Microsoft was bundling these two products to expand market power; could deter other companies like Netscape from entering market

• Microsoft argued it was the next step in technological progress

• What ends up happening?